Hobby vs. Business Taxes: Deductibility of Expenses

If you have a hobby that produces income, your hobby income is taxable. But what about hobby expenses and losses? Whether or not you can deduct hobby expenses and losses depends on whether you pass the IRS hobby vs. business test. Here’s what you need to know to avoid getting caught by the hobby trap.

Do you have a hobby you enjoy? If you’re good at it, you may have found a way to make the hobby produce some income. And if that’s the case, the IRS expects you to pay taxes on that income. The problem? Unless you can prove to the IRS that your hobby is a real business, you won’t be able to deduct any of your hobby expenses. 

The IRS has always had different rules for the deduction of business expenses and hobby expenses. So let’s talk through the differences you need to know.

Understanding Hobby Income and Expenses

Hobby income and expenses can be a complex topic, especially when it comes to tax implications. The IRS requires taxpayers to report all income, including hobby income, on their federal income tax return. However, the tax treatment of hobby income and expenses differs from that of business income and expenses. To understand the tax implications of hobby income and expenses, it’s essential to know the difference between a hobby and a business.

A hobby is an activity engaged in primarily for a purpose other than to make a profit. The IRS often classifies activities like art, photography, crafts, writing, antique or stamp collecting, or training and showing dogs or horses as hobbies. Even if a hobby occasionally generates income, it’s still considered a hobby if the primary motivation is enjoyment, not profit.

In contrast, a business is an activity engaged in primarily to earn a profit. The business owner likely enjoys the activity, but their primary goal is making money.

That definition might have you feeling like there’s some wiggle room. And it can certainly seem like a gray area, especially since some legitimate businesses have their roots in hobby income. But it’s an important distinction to make. To be able to deduct expenses related to an activity, your activities must be categorized as a business for tax purposes. The IRS uses the “hobby loss rule” to determine whether an activity is a hobby or a business.

Business Deductions

If you’re running a business, most ordinary and necessary business expenses are deductible from your business income. Additionally, if you’re operating as a sole proprietor and the direct costs of doing business exceed your income from the business, you can use the resulting loss to offset (reduce) other income reported on Form 1040.

Related: What is a Sole Proprietorship?

Hobby Expenses Deductions

The IRS has different rules for activities it considers hobbies. The main difference is that hobby expenses are no longer deductible even when you make some income from your hobby.

Before the Tax Cuts and Jobs Act of 2017 (which went into effect in 2018), people who weren’t running a business but who were making some income from a hobby could deduct their hobby-related expenses as miscellaneous itemized deductions (a type of itemized deduction) on Form 1040 Schedule A. These miscellaneous itemized deductions were subject to specific limitations, which have been eliminated from 2018 to 2025 under the current law.

Under the current law, if your income-producing activity is considered a hobby by the IRS, you have to report the hobby income, but can’t deduct any of the expenses.

Hobby vs. Business Income

The question of whether an activity is a business or a hobby has always been problematic for people who make money from activities that are usually done for sport or pleasure, such as starting a photography business, painting and drawing, soap making, or jewelry making. That’s because some people try to claim their hobbies are businesses just so they can deduct the costs of enjoying that hobby.

On the other hand, it’s common for people who are good at hobbies to turn their hobby into a business. And, like starting or running any business, there can be years when you don’t make a profit.

In some past cases, the Tax Court disagreed with taxpayers regarding the classification of hobby expenses, reinforcing the importance of correctly categorizing your activities. So, what can you do to keep the IRS from declaring your hobby-related business a hobby?

Profit motive is critical

How does the IRS decide whether something is a business or a hobby? The key is whether you can show the IRS that you have a profit motive for engaging in the income-producing activity. If your business involves something others do as a hobby and you lose money year after year, you could have your business deductions disallowed.

This distinction significantly impacts the taxable income of individuals engaged in hobby activities.

Tax Implications of Hobby Income

Hobby income is subject to income tax but not self-employment tax. Hobby income is reported on Form 1040 (Schedule 1, line 8).

In the past, hobby expenses that didn’t qualify as business tax deductions. Instead, they were considered miscellaneous itemized deductions, which were subject to a 2% adjusted gross income (AGI) limitation.

But for tax years 2018 through 2025, miscellaneous itemized deductions, including hobby expenses, are not deductible. However, taxpayers can (and should) still report hobby income on their tax return. If the hobby generates a loss, the loss is not deductible, and the taxpayer cannot claim a net operating loss. It’s essential to keep accurate records of hobby income and expenses to report on the tax return.

Taxpayers should also be aware of the tax implications of converting a hobby to a business. For example, certain business types are subject to unique tax types. Your state will probably also require you to get a sales tax permit and collect sales taxes. And you’ll also be expected to pay self employment tax on the income you receive from your business. If you do decide to move from hobby income to business income, then be sure you’re prepared for these unique requirements.

How to Avoid the Hobby Loss Trap

The IRS generally will presume your activity is a business if you show a profit in three of the last five years including the current year. There’s an exception, though: businesses involved with racehorses have to show a profit in two of seven years.

If your activity fails this three-of-five-year test, you may still be allowed to declare your expenses as business deductions if you can still prove a profit motive. Here are some of the key factors the IRS will look at:

• Do you carry out the activity in a business-like manner?
• Do you maintain complete and accurate books and records?
• Does the time and effort you devote to the activity indicate your intention to make it profitable?
• Do you have expertise in the activity and knowledge to carry out the activity as a business?
• Are the losses due to circumstances beyond your control, or are they normal for starting your type of business?
• Have you tried to increase the profitability of the activity by changing your methods of operation?
• Do you depend on income from the activity for your livelihood?
• Have you made a profit on similar activities in the past?
• Can you expect to make a future profit from the appreciation of the assets used in the activity?

When a business deduction is challenged on the basis of profitability, decisions are made on a case-by-case basis. But the more ways you can prove your profit motive, the better.

Suppose you’re in business selling hand-painted decorative items, and the business fails the profitability test. The IRS might consider it a business if you:

• have little or no other income;
• regularly work at the business;
• regularly have your items on sale at craft shows, craft malls, consignment shops, or through other means;
• keep accurate and complete records of your costs, inventory, and sales;
• have a separate bank account for your business activities;
• or have made changes in your business to try to counteract the losses.

On the other hand, if you only work sporadically at the business, decorate your own home with your handiwork or give them as gifts, don’t keep good records, don’t regularly offer your products for sale to the public, or never analyze income and expenditures or make and carry out plans to increase profitability, the IRS is likely to declare that your “business” is a hobby.

For more information, see the Not-for-Profit Activities section under the Deducting Business Expenses chapter of the IRS Publication 535.

Conclusion

Understanding the distinction between a hobby and a business is crucial for tax purposes. The IRS sets clear guidelines to determine whether an activity qualifies as a business, primarily based on profit motive and operational structure. If your goal is to turn a hobby into a business, maintaining accurate records, demonstrating a commitment to profitability, and operating in a business-like manner can help you avoid the hobby loss trap. And if in doubt, please work with a qualified tax professional to help make sure you’re complying with tax requirements for your hobby or your business.

Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.